Monday, 5 January 2015

Inflation – Hard to ignore again

Low inflation is a nuisance
for central banks looking to increase interest rates but they would be wrong to
dismiss it

Family get-togethers over Christmas often involve naughty
children but it is inflation that is making trouble for central banks. Inflation unexpectedly shot up in the
aftermath of the global financial crisis but is now surprisingly falling
despite a burgeoning economic recovery.
Central banks ignored the jump in inflation in 2011 and are now stuck
figuring out how to deal with persistently low inflation. The antics of inflation will be difficult to disregard
a second time around considering that the causes for static prices are not all
external.

The best recent example of this was a plague of high
inflation in 2011 when the economies of many countries were still in the
doldrums. The Chinese economy was still
humming along despite financial turmoil elsewhere and China continued to buy up
commodities on the global markets. The result
higher prices were most prominent in the UK where inflation topped five percent
in 2011. This bout of inflation was not
just a brief spike with prices rising by more than four percent for over a year. Despite inflation being well above its target
of two percent, the Bank of England maintained its loose monetary policy to
support the weak economy. The argument behind
this was that the inflation was temporary and not related to the underlying
economy.

Behaving badly again

Inflation is currently misbehaving in a different way and is
causing concern due to being too low.
Prices are not rising by much due to lower commodity prices with the
spurt of growth in emerging countries having run its course. While this is a positive for consumers who
benefit from a boost in spending power, low inflation is a source of anxiety
for central banks. The Federal Reserve
and the Bank of England are getting set to increase interest rates to more
normal levels. Even the prospect of the
economic recovery gaining further momentum would not provide central banks with
enough of a reason for higher interest rates when inflation is around one percent.

This irritation is not likely to go away anytime soon if the
high inflation in 2011 is any guide.
Inflation is likely to slip even lower in 2015 as the effects of the
plunging price for oil feeds through into the economy. On top of this, swings in commodity prices tend to last for a few years so that inflation is unlikely to pick up
for the next couple of years. This would
suggest that inflation will be below target for 2015 and 2016 which is the
two-year time frame that central banks look at when deciding interest
rates.

Ignoring inflation
would be naughty

Low inflation should imply low interest rates but central
banks could choose to ignore this and raise interest rates away. This is because the same argument as in 2011
could be applied – disregarding trends in inflation that are attributed to outside
sources. It is a convenient strategy for
central banks worried about the economic recovery triggering a jump in inflation
due to the potential for wages to rise as unemployment falls. Such an outcome does seem optimistic
considering that wages are not budging by much even as the economy picks up
steam.

A further problem with turning a blind eye to inflation is
that it is tough to gauge what the inflation level would be without the fall in
commodity prices. It is not as if
consumers have money to spurge having been stuck with stagnating wages and
considerable debts from the pre-financial crisis spend-up. Sluggish prices are harder to dismiss
considering that low inflation is also caused by weak domestic demand. With inflation likely to continue to play up
for a while yet, central banks will need to be patient and bide their time before
raising interest rates or else it will be the central banks that may be the
ones getting into trouble.